Web Feature
DECEMBER 2002

The Income Statement


Understanding Income Statements, Balance Sheets and Cash Flow Statements


by Diane Graese

Learn how to use an annual report's financial statements in this workshop. Diane Graese describes how to use the balance sheet, income statement, cash flow statement, and MD&A (Management Discussion and Analysis.)

The workshop uses the 1998 Diebold, Inc. online annual report as an example. You may review the complete report online if you would like to prepare for the discussion that follows.


Introduction

Welcome to the Better Investing School Financial Statements Workshop. The workshop consists of four individual sessions.

Session #1 presented a brief history of financial statements and Generally Accepted Accounting Principles (GAAP). Session #2 covered the Balance Sheet. This session will discuss the Income Statement. Session #4 will cover the Statements of Cash Flows.

Workshop Resources

The workshop uses the 1998 Diebold, Inc. online annual report as an example. We thank Diebold for permission to duplicate selected financial statements for workshop illustrations. The four annual report sections for this workshop are:

I will cite information in the illustrations as the workshop progresses. Selected lines on the financial statements have been highlighted in yellow to identify references used in the workshop sessions. Similarly, text in the MD&A illustration in a bold blue font identifies material referred to in the workshop.

Please note that the workshop illustrations taken from the Diebold annual report present dollars in thousands except per share amounts. However the text of the workshop sessions will present dollars in their full unit value i.e. $42,540,000 rather than $42,540 as in the financial statement illustration.

The Income Statement - An Introduction

The income statement is a required financial statement. It presents a picture of the results of business operations over an arbitrary period of time. We use this statement to examine the business model -- how the company makes money.

Revenues and sales are also called INCOME. They include amounts charged to customers for the sale of inventory or for services provided. Other sources include interest earned or gains on the sale of non-operating assets.

There are many accounting rules regarding revenue recognition. They generally involve determination of when ownership interests change or when contracted services are complete. They do not consider whether or not the company has been paid.

Expenses are the costs incurred to create revenue and otherwise run the business. Operating expenses include the cost of inventory sold, employee compensation, marketing, and selling costs. Administrative expenses include executive salaries, professional fees, and insurance.

Accounting principles require that all revenues and related expenses be recorded in the same period. Thus expenses are often estimated long before the ultimate bill is received and paid. This is necessary in order to present a fair picture of the amount earned.

What Is It? -- An Asset or Expense, According to GAAP

A company expends resources to develop new products or product improvements, develop a loyal customer base, and build a brand name. These expenditures are all investments in the future of the company and are intended to generate future revenues.

Some of these expenses will create something of value; others will not. Generally Accepted Accounting Principles (GAAP) are usually very conservative. GAAP treats internally generated costs as expenses that are included in the income statement. By default, some valuable assets become hidden from the balance sheet.

An acquiring company recognizes the value of these assets when it determines a purchase price. When there is a known purchase price, GAAP is willing to recognize the value of these assets and place them on the balance sheet, generally as purchased GOODWILL.

Goodwill is presumed to generate future revenue. Its use will get recognized as a non-cash expense in the income statement through an accounting allocation called amortization.

Are you confused by these apparently conflicting treatments? You are not alone. That's why it's important to have some idea of how accounting can influence earnings.

Earnings Per Share

The SEC only requires computation and disclosure of one ratio -- Earnings per share (EPS). Accountants have changed the accepted method of calculation many times. Currently calculations of BASIC and DILUTED EPS are required. EPS is calculated by dividing net earnings after preferred stock dividends by the average number of outstanding common shares.

The Impact of Stock Options

Management is frequently compensated through stock option awards. Options give the right to purchase company stock at some time in the future based upon today's price. This encourages management to take actions which will increase the value of the company.

This right has value to management. The issuance of stock at less than full value in the future has a cost to shareholders. Neither of these amounts are reflected in the income statement.

The calculation of Diluted EPS considers the issuance of these future shares. Notice that Diebold shows very little difference between basic and diluted EPS. At some companies, the difference is quite significant.

I always use Diluted EPS in my analysis of a company. I have faith management will increase the value of the company. I am confident those shares will be issued in the future.

Management Discussion: The Results of Operations

Diebold's MD&A discusses the reasons for the decline in sales in 1998. The narrative discusses expenses and gross margins both as numbers and as a percentage of sales.

Diebold goes all out to be investor friendly and presents the analysis in a table. For those of you who hate number crunching, reading this disclosure can save a lot of work.

The Diebold MD&A narrative gives details about the realignment and special charges ($61,117,000) that are included in pre-tax income. Reading this disclosure allows the investor to decide whether these items are truly UNUSUAL.

NAIC investors are well aware of the judgments needed to estimate future revenues and earnings. While past trends can be a guide to the future, I feel more confident about my judgments after reading management's analysis. Use MD&A to improve your understanding of the company's operations.

Session #4 begins the discussion of the Statement of Cash Flow.

Session #3 - Questions and Answers

Cy Lynch:Now that you are through with balance sheets and income statements, I have a question concerning asset valuation. Could you explain Asset Impairment loss in some detail. As I understand it, it is a decrease in the value of an asset effected by a credit to the asset account and a debit to an extraordinary expense account. One example is a charge that American Greetings (NYSE: AM) took in November 1995. What I am not clear on is the following:

  1. When may management recognize an asset impairment loss?
  2. When must management recognize an asset impairment loss?
  3. How is the asset's "impaired" value determined?
  4. What other types of asset "write-downs" are there and how do they differ from asset impairment loss?

Diane: The topic is very complex and I have been away from public accounting for over 10 years. I know there have been new rules issued in those 10 years. Plus any great detail would bore some to tears. (Big Grin) What I can do is give you a general view of the topic.

At every reporting date, management must evaluate whether the recorded value of an asset exceeds its worth. Accounting doesn't worry if the value is greater. When questioned by auditors, management must provide support for their valuation. Auditors must determine whether the assumptions used are reasonable.

Worth is dependent on how the asset will be used in the business. As an example, a plant currently used for producing a product will generally be deemed to be worth its full depreciated historic cost. A plant which is held for sale will be deemed worth only its recoverable value upon sale after consideration of selling expenses. Every asset must be evaluated:

Receivables: Can they be collected for full value? If not, management must estimate a reserve for bad debts.

Inventories: Are they carried at a cost which is less than or equal to a current selling price? If not, a valuation reserve must be recorded.

Even though I'm an accountant, I rely on management and the auditors to use proper accounting methods. Granted, sometimes it isn't the case. But when even the auditors (who have full access to the books and records) can't find fraud, how will I?

Cy Lynch: Another issue that I don't understand deals with write-downs/write-offs of inprogress R&D (research and development) when one company acquires another. I am interested in the mechanics of applying the applicable GAAPs, but am even more interested in the supposed rationale for recognizing the expense. Why would research and development (R&D) suddenly become less valuable or worthless when a company is acquired? I thought that in-progress R&D was one big reason that technology and drug companies (to name two examples) were acquired.

Diane: This is a very hot topic... witness the SEC inquiry into the accounting at Network Associates. The general concern is that managements have become very aggressive in taking write-offs and one time charges. Are the charges legitimate or is management including future expenses just to make future profits look better? This concern also extends to restructuring reserves. You will see a lot of press as the SEC, accounting profession, and industry deal with the issues raised. Today, most companies have more than one R&D project going on. When a company is acquired, the new management has to decide how the new company will fit in with current operations.

As transitions take time, the company continues to operate AS IS until new decisions can be made. It is often several months later when management may deem certain projects to no longer fit with the direction of the combined enterprise. At this point certain R&D becomes worthless. This is one reasonable example of how purchased R&D could later become worthless.

Ellis Traub: A question arose a few days ago concerning Return On Equity. I made the statement that, when doing Section 2 of the Stock Selection Guide, I'm less concerned about 2B, ROE, than I am about Profit Margins - 2A. I gave the reason that there were a number of things that could cause a decline in ROE but would be deceptive in that they were not detrimental. Declines in debt (which cause a decline in ROE) are one example; but there are others that don't come to mind. Can you help me here and suggest some other reasons not to be concerned with a decline in ROE?

Nola Serra: How about when a company is building up cash for future acquisitions? Mity-Lite comes to mind. For 1998, cash was 25% of assets.

Allen Theobald: Declines in debt (which cause a decline in ROE)... Sorry, Ellis, I think I'm following you on this. But please explain.

Zeydy Ortiz: We have been discussing Return on Equity (ROE) in our club and I intuitively understood this part. A light finally went ON in my mind when I studied the components of ROE. I'll see if I can explain my thinking clearly and will appreciate any corrections. We normally calculate ROE by dividing earnings per share (EPS) by the book value (BV) per share. An equivalent formula is to divide Net profit by the shareholder's equity. The Dupont identity expands ROE into three components: Profit Margin, Asset Turnover, and Financial Leverage. They are defined as:

  • Profit Margin = Net Profit / Sales
  • Asset Turnover = Sales / Assets
  • Financial Leverage = Assets / Equity

Multiply the three components. Sales and Assets cancel and you are left with: ROE = Net Profit / Equity The last component, Financial Leverage, is the one to observe for clues on a company taking on more debt. We have heard that if a company is getting into debt, financial leverage will be higher and ROE may look good because it will increase. My problem was that debt is not in the financial leverage formula, at least not explicitly. Why is it a bad thing if I increase my assets, I thought. Well, we know that in order to have a BALANCED balance sheet, Assets = Debt + Equity. If assets increase but equity remains the same, the increase is due to more debt.

One way to keep track of financial leverage in ROE is to look at the trend in the Debt-to-Equity ratio. Financial leverage is also defined as: (1 + Debt/Equity)

Diane: The NAIC Official Guide: Starting and Running a Profitable Investment Club (in my copy it's in Chapter 9, page 87) states, "Accountants also calculate earnings on equity in different ways. For instance, some base it on beginning equity and others on ending equity. Some base it on the average of beginning and ending equity. The differences are not usually important..."

The differences are not important so long as the change in equity is related to earnings from NORMAL business operations. Let me explain a few quirks which can influence the calculation.

The SSG form and Toolkit calculate ROE using the formula EPS / Book Value per share. This results in the equation: Earnings (Net Income)/Shares times Shares/Book Value (Equity).

Zeydy explained that the shares SHOULD cancel out. But in most cases they won't. Earnings are earned over the course of a year. The EPS calculation uses weighted - average outstanding shares throughout the period. At Diebold, 68,960,000 shares were used to calculate basic EPS. You can find this number near the bottom of the income statement. Book value per share is calculated as of the balance sheet date and uses outstanding shares as of the balance sheet date. At Diebold, book value would be calculated using the 68,880,761 outstanding shares at December 31, 1998. This figure is on the balance sheet under common shares.

At Diebold, the difference is not significant. But consider the differences which can be created via LARGE stock issuances or repurchases. So, besides focusing on changes in debt, one must also consider significant changes in equity.

The next issue has to do with cash. As Nola states, too much cash can hurt ROE. Earnings on cash are usually less than the margins earned on normal business. But if the company has a good game plan for the cash, I don't mind waiting.

A third issue is EPS. You may have adjusted EPS for unusual items, but the gain or loss WILL be included in equity. Consider Dover Corporation. On January 5, 1999, the company sold it's elevator division generating $2.35 per share gain. (1998 EPS was $1.70) The after-tax proceeds from sale were estimated at $800 million. The company is slowing buying in some shares and looking at acquisition targets, but this is a LOT of cash.

I fully expect to see a decline in ROE in the current year. I will not include the $2.35 in 1999 EPS, but the after-tax gain will be included in Equity.

Ellis: I understand that the Deferred Tax issue is important here since some companies call it a liability and others an equity entry.

Diane: I treat Deferred tax credits as a liability. I do not include it with debt. I don't recollect seeing a balance sheet where it was included in shareholder's equity, but I've often seen it in limbo-land ... on a separate line between long-term liabilities and Shareholder's equity. I recollect two theories for including deferred tax credits in equity.

1. Deferred taxes can also be an asset (as they are at Diebold). Since Assets = Liabilities + Equity... Deferred tax debits are included in equity. Therefore, deferred tax credits should also be viewed as equity. Deferred taxes are Deferred taxes and debit vs credit balances shouldn't make a difference how they are characterized.

2. Assuming the business continues to operate and grow, deferred taxes never really become payable. Witness the huge deferred tax credit balances carried on the balance sheet of most utility companies. These are largely the result of differences in book and tax accounting for the deduction of the cost of fixed assets. Other credits can be the result of providing U.S. taxes on income from certain foreign operations. No tax will be due in the U.S. until these earnings get repatriated to the U.S. Therefore, again, the taxes may never come due. And the government may change the tax laws which would render some of these amounts meaningless.

The income tax footnote in the annual report will breakdown the source of deferred tax debits and credits. This may help you decide how you wish to treat these balances. (Now my head is spinning...)

Ellis: You said: "The differences are not important so long as the change in equity is related to earnings from NORMAL business operations. So besides focusing on changes in debt as you mentioned in your post, one must also consider significant changes in equity. A third issue is EPS. You may have adjusted EPS for unusual items, but the gain or loss WILL be included in equity." The bottom line, here, is that one should be critical when dealing with Sections 2A and B. The novice would be best advised to not accept declines in either. However, there are times -- for reasons that are quite obscure and difficult to dig out (such as those that you provided, thank you) when 2B (ROE) will decline with reasons that are not unfavorable.

I think it safe to say, don't you Diane, that favorable profit margin performance (in 2A), with an appropriate growth in earnings, should reduce concern about 2B since most changes in equity that would cause the ROE to decline are apt to be favorable or neutral. For that matter, most growth in equity is favorable to the shareholder. In any event, my original comment -- that I tend to be less concerned about 2B than 2A -- should make more sense now with your help.

Diane: I agree. Ellis your earlier comments said you tend to focus more on pre-tax margins (SSG Part 2A) than on ROE (SSG Part 2B). This is part of your judgment process in analyzing all the data on the SSG form. And since you are an experienced investor, I think all are wise to respect your opinions.

I am stepping out on a limb to offer my personal opinion: I'm critical of all the parts of the SSG. I find that how critical I am about each particular piece of SSG data depends on the company. I treat small growing companies different than the large behemoths. I treat stocks in certain specialized industries different than companies in less regulated or competitive situations.

And I have some personal biases. You all should know by now that I like my companies to have earnings supported by good cash flow and to have very little debt. (Grin) All other things being equal, I generally focus most on revenue growth, PE range and estimated downside risk.

As a retiree, I have to make sure I don't lose my money. I am content to accept a money market rate until I find a GREAT candidate in which to invest. (It never takes more than a few months and I am very patient.)

When calculating downside, for any dividend paying stock, I always consider the lowest price based on what the dividend will support. Then I consider whether there is anything detrimental on the horizon which would cause the company to cut the dividend. In this sense, I am often a bottom-feeder looking for high quality companies. The dividend and my calculated downside vs. the current price were significant considerations for me when I made my purchases of Dana and Diebold after meeting company representatives at Congress in San Jose last fall.

Why revenues and P/E? Because earnings growth and ROE can be "manipulated" for short periods of time. Revenues are the ultimate source of growth. P/E is a very good historical perspective of what the market has felt the company is worth. I believe the market trades in cycles and usually reverts to a norm. Buying at low or reasonable P/Es is just another way to help limit my downside risk.

I have missed a lot of potential wealth building in the market because of my rules. (The closest I am to an Internet stock is Cisco Systems.) But I sleep at night. As others have said, it is your DISCIPLINE to solid investing principles (whatever system you use) which will make you wealthy in the long run.

Dan Hess:Diane, in following this thread on what specifics to use for EPS and BV when calculating ROE, I conclude it really does not matter because what we are interested in is seeing if the ROE trend either rising or at least staying flat. While differences, such as using YE BV vs the average of the beginning of year and end of year will result in different numbers, the effect in most cases will prove to be insignificant. The important part is to use data that is consistent -- normally achieved by using a single source like VL. Have I correctly interpreted this?

Diane: YES...YES...YES.

Joe Smith: Diane, Your point about focusing on revenue growth is a good one. It's something that I first heard from Charles Allmon about 30 years ago and it still makes sense. If I believe that, over years, stock prices tend to follow EPS growth then, by saying that they "tend" to follow EPS, I recognize that there will be times when the prices and the EPS are a bit out of kilter. This could well be the manipulative period of which you speak. However, they will eventually get back in line. As Ellis often says, the company has a "footprint" for P/E relationships that do come back to normal.

On the other hand, revenue growth is a more consistent scorecard from my perspective; without revenue growth, there is little chance for earnings growth since, as we all know, EPS comes from revenue growth. There are many variables that can effect EPS but revenues only come from a good job done by management. But, even there, there could be temporary variables to effect revenue growth ... economic turndowns (a la Asia meltdown), strikes, acts of God, etc. But, these are well-known events. Creative accounting on the other hand may go unnoticed but can -- on the short-term -- make EPS growth look good.

Isn't it interesting that the more we know about investing, the more we learn that we don't know!

Diane: Actually I find it more interesting that the more time I spend reading other's theories of investing, the more I realize how simple it is for the average investor to succeed with a few good tools and some common sense.

I think the hardest part of my investing education has been realizing that my common sense ideas are really a valuable part of the equation. I think a lot of us have trouble feeling comfortable in our ability to make judgments. But in the short time I have spent with all of you on I-Club-List, my confidence level has improved 100%.

Continue to Session #4 - Statement of Cash Flows

Return to Session #1- Introduction to Financial Statements

Return to Session #2 - Balance Sheet

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.